Sep 14, 2016

Reading Frank H. Knight's "Risk, Uncertainty, and Profit"

The true uncertainty in organized life is the uncertainty in an estimate of human capacity, which is always a capacity to meet uncertainty.

Frank Knight

It is the first time I read RUP. There are a few points I would like to make:

This is an incredibly good book to understand the origins of entrepreneurial profits. Profits are the reward for an entrepreneur's good judgement when she faces uncertainty. And uncertainty is a kind of risk that can not be measured.

The book starts with a methodological discussion and Knight indicates the importance of clarity for scientific endeavors. In particular Knight emphasizes that scientists should be transparent about explaining the assumptions of their models. By the way, for Knight there are no economic laws, only tendencies.

The exploration of assumptions is key for what Knight does in RUP. In particular he describes the perfectly competitive model and explains its assumptions. By doing that he concludes that in this model profits do not exist. However, in reality, profits do exist. And the reason is that in the real world information is not perfect and there are barriers to entry, among other factors -- there is uncertainty! By dissecting the assumptions of a theory (perfect competition) Knight creates a new theory (a theory of profits).

Once the assumption of perfect information (and others) is relaxed we see the emergence of uncertainty. Uncertainty as explained by Knight has different origins. One is the changing nature of the world, which is partially explained by unpredictable human behavior.

On the one hand, perfect competition is situated in a static world where there are no barriers to entry. Imperfect competition, on the other hand, is situated in a dynamic world. Profits do exist and are taken by entrepreneurs that exercise their good judgment when facing uncertainty. For Knight entrepreneurial good judgement cannot be precisely distinguished from good luck. An interesting topic to discuss is what exactly "good judgment" is, and to what extent good judgment can be taught.

Once one accepts the importance of good judgement it is easy to understand the implicit theory of the firm in RUP. For Knight entrepreneurs are specialized in maximizing good judgement and they create companies to do so. Entrepreneurs are also specialized in wealth creation. A related point here is that stockholders are the entrepreneurs in modern corporations.

Who is the entrepreneur? She has "skin in the game," and she is residual claimant of income after the prices of the factors of production (land, capital, and labor) have been imputed.

It is possible to reduce uncertainty, by grouping different events. Another way (although extreme) to do so is to stop progress.

Knight argues that human beings maximize wealth, not consumption. He also indicates that human beings are constantly looking to have "interesting" lives.

Knight was a pioneer of what we call now behavioral economics. He mentions that human beings do not necessary know what they want. Psychology is important and that opens the door for manipulation through marketing. He even mentions what would be known as the "winner's curse." For Knight preferences are not constant, and human beings are often trying to acquire better preferences.

There is much more in the RUP, and if you have not read it and are interested in entrepreneurship, market process, microeconomics, and risk RUP is a must. Besides, Frank Knight had a fascinating approach to social sciences. He was critical, skeptical, and a heretic in many ways.

Additional readings

These additional readings helped me understand the RUP better and to contextualize Frank Knight and his thinking - they are in no particular order:

Raines, J. Patrick, and Jung Clarence R. "Knight on Religion and Ethics as Agents of Social Change: An Essay to Commemorate the Centennial of Frank H. Knight's Birth." The American Journal of Economics and Sociology 45, no. 4 (1986): 429-39.

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